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Conceptual Framework - Elements of financial statements

Date recorded:

The staff presented to the Board an early draft of the section on the definition of equity and the distinction between liabilities and equity instruments that would be included within the Conceptual Framework discussion paper (DP).  The Staff noted that this section of the DP would discuss:

  • How the Conceptual framework would define equity
  • Whether the definition of a liability should be used to distinguish liabilities from equity instruments

The Staff noted that the section on the definition of equity and the distinction between liabilities and equity instruments that would be included within the DP would attempt to address the following problems with the treatment of equity instruments and the distinction between liabilities and equity instruments:

  • Financial statements do not show users clearly how higher ranking equity instruments affect possible future cash flows to users.
  • Existing IFRSs do not apply the definition of a liability consistently in distinguishing financial liabilities from equity instruments.
    • The exceptions are complex, difficult to understand and difficult to apply, and cause many requests for interpretations.
    • Inconsistency makes financial statements less understandable, and creates opportunities for structuring.

The Staff noted that the DP would not propose a change to the existing definition of equity.  The DP would note that existing and potential investors need information about:

  1. the future net cash inflows to the entity; and
  2. the claims on those net cash inflows.

The Staff noted that the section on the definition of equity and the distinction between liabilities and equity instruments that would be included within the DP would propose that an entity should provide the information that investors need as follows:

  • information to help them assess the amount, timing and uncertainty of future net cash inflows to the entity: in the statements of financial position, comprehensive income and cash flows, and in the notes.
  • information about the claims on those net cash inflows: in the statement of changes in equity. This statement, with related notes, would be designed in a way to enable equity holders to understand:
    • the claims of all higher ranking equity holders (equity holders with a higher claim on the entity’s total equity); and
    • the changes during the period in those claims.

The Staff noted that the section on the definition of equity and the distinction between liabilities and equity instruments that would be included within the DP would propose that the statement of changes in equity be designed so that:

  • An entity would remeasure at the end of each period each class of instrument, other than the most residual class. An entity would not remeasure the most residual class, because that would require a measurement of the entity as a whole, which is not the purpose of general purpose financial statements.
  • Remeasurements would result in transfers between the amounts attributed to different classes of equity. These would represent transfers of wealth between those classes.
  • The statement of changes in equity displays a separate column for each class of equity instrument.
  • If equity includes different components, such as share capital or reserves, the entity would allocate those components to classes of equity on a basis consistent with legal and other requirements governing the entity.

The Staff noted that the section on the definition of equity and the distinction between liabilities and equity instruments that would be included within the DP would state that this approach would:

  • give equity holders a clearer and more systematic view of how other equity claims affect them.
  • provide a way to resolve some liability/equity classification issues that have proved problematic over the years.

The DP would note that the IASB would need to decide at a standards level what measure to use for particular classes of instruments.  The DP would comment on approaches such as amortised cost and fair value.

The Staff noted that this approach was largely consistent with how IFRSs treat non-controlling interests in a subsidiary.

The Staff noted that the section on the definition of equity and the distinction between liabilities and equity instruments that would be included within the DP would provide a discussion of distinguishing liabilities from equity instruments and would note that the distinction between financial liabilities and equity instruments is currently governed by IAS 32 and IFRS 2.  The DP would note that in both standards the starting point would be to determine whether the entity has an obligation to transfer economic resources but would note that there are exceptions that are applied to this rule, especially with IAS 32.  The Staff noted that such an approach has disadvantages such as applying and understanding these complex exceptions.  The Staff also noted other issues with this approach such as:

  • Inconsistency with the definitions in the conceptual framework making financial statements less internally consistent, and as a result, less understandable.
  • Providing opportunities to structure transactions to achieve a more favourable accounting result without changing the economics of a transaction significantly.
  • Inconsistency with the approach used for share-based payment in IFRS 2.

The Staff noted that the section on the definition of equity and the distinction between liabilities and equity instruments that would be included within the DP would identify two ways to simplify the distinction between liabilities and equity, a one-step approach and a two-step approach.

The one step approach would:

  1. Classify as equity only current and future holders of the most residual existing class of equity instrument issued by the parent.
  2. Classify as liabilities all other instruments, such as:
    • instruments that create no obligation to transfer assets
    • non-controlling interests (NCI)
    • forwards and options on the instruments classified as equity by the criterion in (a)).
  3. Recognise interest on all instruments classified as financial liabilities, and all gains and losses on them in profit or loss.

The two step approach would:

  1. Classify as liabilities only obligations to deliver economic resources. Thus, the statement of financial position would show the entity’s resources and obligations, and the statement of comprehensive income would show changes in those resources and obligations (an entity perspective).
  2. Classify as equity all equity claims, in other words:
    • all claims that may enable the holder to receive distributions of equity
    • all obligations to deliver equity instruments.
  3. Remeasure all equity claims, other than the most residual. Thus:
    • the equity section of the statement of financial position would show how all equity claims affect other claims.
    • the statement of changes in equity would show wealth transfers between different classes of equity claims.

The Staff noted that the section on the definition of equity and the distinction between liabilities and equity instruments that would be included within the DP would recommend the two step approach.  The Staff noted to the Board that the DP would favour the two step approach because:

  1. It would provide a clearer, more understandable, more consistent, less complex and more easily implementable distinction between equity and liabilities.
  2. It is consistent with the existing definition of a liability, and with the existing treatment of non-controlling interest.
  3. It would separate more clearly two important distinctions:
    • Does the entity have an obligation to transfer economic resources?
    • Does an instrument affect the returns to existing holders of the most residual class of equity instrument?
  4. Remeasurement of all equity claims, other than the most residual, will provide equity holders with clearer and more prominent information about the effects of other equity claims.
  5. It would eliminate the inconsistency between IAS 32 and IFRS 2.
  6. It would require remeasurement for all share-based payment, thus removing one source of complexity from IFRS 2.

The Staff noted that in applying the two step approach at a standards level, the IASB may need to address some other issues such as how to measure written put options on an entity’s own shares and written puts on non-controlling interest.

The DP proposed possible approaches how to measure written puts on an entity’s own shares and noted that the DP did not provide a conclusion on this matter.  The Staff highlighted that the current version of the DP did not also provide a conclusion on NCI puts.  The Staff noted that they will include examples for a written put in the next version of this section of the DP.

The Staff noted that the section on the definition of equity and the distinction between liabilities and equity instruments that would be included within the DP would propose that the exception in IAS 32 for treating some puttable instruments as if they were equity instruments would still be valid and the Conceptual Framework would need to indicate that an entity should treat some obligations that oblige the issuer to deliver economic resources as if they were equity instruments (the Staff noted that this might arise if the obligations are the most subordinated class of instruments issued by an entity that would otherwise report no equity.  It was noted that whether to use such an approach would be a standards level decision.

One Board member commented that he did not think that there should be an exception for puttable instruments and asked the Staff whether this issue could be resolved without having to create an exception.  This Board member asked whether the definition of a liability could be amended to state that in certain circumstances where there is an obligation to pay cash there was not a liability.  The Staff noted that this would be explored further.

The Staff asked the Board members whether they agreed that:

  1. An entity should:
    1. remeasure at the end of each reporting period each class of equity claim, other than the existing holdings of the most residual claims
    2. recognise those remeasurements in the statement of changes in equity, as a transfer of wealth between classes of equity claim
  2. Obligations to issue equity instruments are not liabilities
  3. Obligations that will arise only on liquidation of the reporting entity are not liabilities
  4. If an entity has issued no equity instruments, it may be appropriate to treat the most subordinated class of instruments as if it were an equity claim, with suitable disclosure. Identifying whether to use such an approach, and if so when, would still be a standards level decision.

During the Board meeting the Staff provided an example that applied both the one step and two step approaches.  One Board member commented that this was a good solution to solving some of the problems, as noted above, but also noted that he foresaw additional issues.  He commented how the EPS calculation would be affected and how the wealth transfer (that would be shown within the statement of changes in equity rather than the statement of comprehensive income) would be taxed if it were subject to tax as it would not be showing directly in the statement of comprehensive income.  The Staff answered that they had not considered the tax implication and would consider this.  This Board member commented that the two step approach would solve some problems and create a number of others and asked that the Staff consider these and include a discussion in the DP.

Another Board member was concerned with the concept of wealth transfer and providing disclosures so that users would understand what this related to.  The Staff noted that the label “wealth transfer” could be changed to be more prescriptive on the statement of changes in equity and there may also be a requirement for a level of disaggregation that could be considered.  This Board member was also concerned that interest expense in the example was shown as an equity transfer rather than within the statement of comprehensive income.  This Board member also asked whether the statement of changes in equity would also be considered a performance statement (i.e. the wealth transfer aspect) along with the statement of comprehensive income and noted that this may be a step backward for users who seem to want only one statement of performance.  The Staff noted that if the two step approach was pursued then users would need to be educated and the new statement of changes in equity would need to be given greater prominence.

One Board member commented that he agreed with the general direction of the DP and the proposals to remove some of the current issues with IAS 32.  However he noted that the two step approach was introducing a new concept of wealth transfer that was creating a conflict with the concept of expenses.  One Board member commented that the Staff should ensure that the two step approach is not replacing the investor perspective with a solely shareholder perspective (through the use of the term wealth transfer) and commented that both user groups needed to be considered.

Overall there was a general amount of Board support for pursuing the two step approach.  However there were no tentative conclusions as to whether this is an approach that the Board would choose – the Board tentatively agreed that this approach should be explored further.  The Staff noted that they would consider the Board comments made and would provide additional examples.  The Staff also noted that the next version of the DP would provide a consideration of alternative approaches that could be adopted rather than just presume that the two step approach would be agreed by the Board.  It was tentatively agreed that changes were required in line with the Board comments above and a more balanced argument put forward in the next version of the DP.